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Style and capitalization ETFs

Style is a widely used term to define a particular investment approach. Different styles have different historical risk-reward characteristics. Mixing styles in an individual’s portfolio is often recommended as a means to achieve diversity and improve performance.

Style ETFs are designed to track a particular investment style and/or asset class. Asset class ETFs include small cap, medium cap, large cap stocks. Investment style ETFs include value and growth. The market cap and investment style can be combined into approaches, such as small cap value, large cap growth, and so on.

Small, Mid, Large Cap

Briefly, a large-cap stock refers to a company with a market capitalization of more than $10 billion. A mid-cap stock refers to a company with a market cap between $2 billion and $10 billion. And a small-cap stock generally refers to a company with a market cap of $300 million to $2 billion.

Market cap performance varies over time. Looking at market history, small and mid-cap stocks have tended to outperform large cap stocks for extended periods of time. However, the performance differential is small and has completely evaporated during certain periods.

To the degree that there is a performance bias in favor of small cap stocks, three explanations are offered: (1) Small cap stock are disproportionately held by smaller investors who often sell stock late in the calendar year for tax reasons. Accordingly, after the late year sell-off, small cap stocks tend to rebound in January. This is known as the January effect. (2) Small cap companies are more likely to go out of business and thus the indices tracking small cap stocks are over-weighted with the stronger companies that have survived. (3) Small cap companies are the growth engine of the economy and a small number generate extraordinary earnings growth, lifting the entire category.

Investors should be aware that many leading equity indices such as the S&P 500, the Russell 1000 and the Russell 3000 are constructed via a market capitalization method which means they tend to be top-heavy in large cap market stocks. Thus, they will perform better when large caps are doing well and will suffer when small and mid cap stocks are outperforming larger stocks. To strike more of a balance between capitalization sectors in an index fund and investor may want to consider index funds constructed via an “equal weight” method, which gives equal weight to small and large companies.

There are hundreds of ETFs to choose from in each of the market cap categories: small, mid, and large. You can customize a portfolio to achieve equal balance between market cap categories or to weight your portfolio to a particular sector. Given historic performance tendencies, a long-term investor may want to consider weighting their portfolio slightly toward small and mid-cap sectors, although investors should always remember that past performance is not indicative of future results.

Value Versus Growth

Growth versus value investing styles have generated many arguments and research among investors as to which is the better approach.

Value investors buy companies whose shares appears to be underpriced relative to the company’s financial performance as reflected in the company’s price-to-earnings ratio, dividend yield, or price-to-book ratio. The most famous value investor in recent times is Warren Buffett.

Growth investors focus on companies that are growing at a fast rate and are expected to generate earnings growth in excess of the overall market and their industry sector. Peter Lynch, who achieved spectacular results as manager of Fidelity’s Magellean Fund, coined the phrase “growth at a reasonable price” which was something of a hybrid of the value and growth approach.

Vanguard CEO John Bogle in his book Commons Sense on Mutual Funds studied performance data for mutual fund from 1937-1997 and concluded that: “For the full 60-year period, the compound total return were: growth 11.7%; value 11.5% -- a tiny difference.” Bogle updated the data through May 2006 and reported a performance differential of just .03%, again a paltry amount.

But while over long periods of time, the performance differential of investment styles tends to converge, there are shorter periods where one style substantially outperforms another style. Investors nimble enough to overweight their portfolios to those styles can generate market-beating returns.

For example between March 24, 2000 and December 31, 2006, the Russell 2000 small cap value index generated a return of 172%, far outpacing broader market indices and other investment styles. The out-performance was likely driven by a recovering economy and may not be repeated in the future. Generally, poorer performing small cap stocks are sold by investors at the first sign of economic weakness and are re-purchased when the economy picks up steam. Indeed, since the beginning of 2007, the index has underperformed the broader Russell 3000 index and the Russell 2000 small cap growth index.

While style ETFs enable investors to weight their portfolios in favor of a particular investment style, it should be noted that picking winning investment styles is very difficult. Perhaps the chief value that style EFTs bring to investors is the ability to balance their style exposures in way that maximizes risk-adjusted growth.

For example an investor who works for a small cap growth company and holds a good deal of company stock may wish to weight the remainder of their holdings toward large to mid cap value stocks to achieve a better overall balance.

Article copyright 2011 by David H. Fry, Richard A. Ferri, and Mitch Zacks. Reprinted and adapted from Create Your Own Hedge Fund, The ETF Book, and The Little Book of Stock Market Profits with permission from John Wiley & Sons, Inc. The statements and opinions expressed in this article are those of the author. Fidelity Investments® cannot guarantee the accuracy or completeness of any statements or data. This reprint and the materials delivered with it should not be construed as an offer to sell or a solicitation of an offer to buy shares of any funds mentioned in this reprint.

The data and analysis contained herein are provided "as is" and without warranty of any kind, either expressed or implied. Fidelity is not adopting, making a recommendation for or endorsing any trading or investment strategy or particular security. All opinions expressed herein are subject to change without notice, and you should always obtain current information and perform due diligence before trading. Consider that the provider may modify the methods it uses to evaluate investment opportunities from time to time, that model results may not impute or show the compounded adverse effect of transaction costs or management fees or reflect actual investment results, and that investment models are necessarily constructed with the benefit of hindsight. For this and for many other reasons, model results are not a guarantee of future results. The securities mentioned in this document may not be eligible for sale in some states or countries, nor be suitable for all types of investors; their value and the income they produce may fluctuate and/or be adversely affected by exchange rates, interest rates or other factors.

ETFs may trade at a discount to their NAV and are subject to the market fluctuations of their underlying investments. ETFs are subject to management fees and other expenses.